Head & Shoulders Bottom Watchlist Methodology
The head and shoulders bottom pattern is recognized as one of the most reliable bullish trend reversal patterns. Bulkowski* reports that 95% of these patterns are successful and make an average gain of 38%. It forms after a downtrend and is characterized by three troughs with the center trough lower than the two adjoining troughs. The neckline is a line drawn between the two intraday highs between the peaks.
Our own research and backtest results are in the Newsletter Archive.
We recognize two types of head and shoulder bottom, depending on the slope of the neckline. We do this so we can recognize a breakout price and issue alerts when this price is met.
When the neckline is flat or slopes downwards, the breakout price is calculated as the point where the neckline intersects the price line following formation of the right shoulder. It is at this point that the pattern is completed and a long position could be opened (or a short position closed). At this time we can calculate a 'target' increase which is the distance between the center trough's low and the neckline. Bulkowski* estimates this target is reached 83% of the time.
If the neckline slopes up, then it is possible that it will never intersect the price line following the right shoulder, so we use an alternative method of detemining a breakout price. In this case we use the resistance level at the left shoulder and calculate the target price as the difference between that resistance level and the center trough's low.
Our algorithm will recognize a head and shoulders bottom pattern when the following conditions are met.
- The stock must be in a confirmed up trend before the pattern begins. An uptrend exists if the the left shoulder is at least 30% lower than the high in the previous 6 months (120 trading days).
- The pattern width, shoulder-to-shoulder, must be 6 months (120 trading days) or less.
- The head must have occured within the last 6 months (120 trading days).
- There must be approximate symmetry to the pattern. We determine this by requiring that number days between the shoulders and the head (a and b in the diagram) must be within 50% of each other.
- There must be a noticeable peak between the left shoulder and the head (c). We chose an arbitrary minimum of 2%. This is measured from the left shoulder intraday low to the intraday low at the left neckline.
- There must be a noticeable peak between the head and the right shoulder (d). We chose an arbitrary minimum of 2%. This is measured from the right shoulder intraday low to the intraday low at the right neckline.
- For downward sloping necklines (Type 1), the breakout price is the the neckline value on the date of the last close.
- For flat or upward sloping necklines (TYpe 2), the breakout price is the value of the intraday low at the left neckline.
- The last close must be below the breakout price.
- The minimum 50 day average volume must be at least 500,000.
- The target % increase must be at least 25%.
* Encyclopedia of Chart Patterns. Thomas N Bulkowsli. 2000. p.262.
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